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What’s good for finance may not be good for the economy

In the wake of the 2008 financial crisis and ensuing recession, whose effects are still with us, governments have put in place complex new regulations which aim to prevent any similar crisis in the near future. Whether or not they will is controversial. But the UK, US and other advanced economies since the 1970s have become what is termed by some economists as ‘financialized’. The latter means that an increasing proportion of economic activity is subject to the behaviour of financial institutions and markets, and a much larger proportion of overall private sector profits occur in the financial sector.

The dysfunctional elements of financialization came to a dramatic head with the credit crunch in 2007, the financial crisis which began in 2008, and a global recession and subsequent weak recovery. Financial innovation, the accumulation of private sector debt and a number of housing bubbles in economies across the world led initially to huge profits for investment banks and other financial institutions, and enormous salaries for many working in the sector. Ultimately however this proved dysfunctional with regards to the role they played in the crisis. What may appear to be success for the individuals and companies involved in finance, at least for a time, can prove disastrous when looking at the wider economic and social impact over the longer term. In sum, the financial sector was incentivized to take on excessive risk, which temporarily boosted profits, but in the end led to a near collapse of the system.

This is not just true for finance. In economics, the concept of negative externalities shows how a firm making profits in the private sector may impose costs on other firms. A common example is that of a polluting firm whose profits do not reflect the extra cost that it imposes on the wider society. Other firms or local governments can end up paying the costs of cleaning up the pollution and this represents an inefficient outcome. Government can impose regulations or taxes which aim to limit the pollution and ‘internalize’ the externality for the offending firm. The latter may then find that production is no longer profitable and close down some or all of its operations. Governments aiming to promote a cleaner environment can thus enforce such ‘market-friendly’ policies, which make polluting more costly and cleaner forms of production more profitable. In this case, in the absence of government intervention, what is good (read profitable) for one firm is bad for the region or economy as a whole.

Returning to the opening example of the financial sector, even though it generated employment, high wages and profits, and significant tax revenues for the government over many years, the costs of the recession can be seen as a form of negative externality which needs to be regulated in some way so as to mitigate or prevent the massive social costs it imposed on the overall economy. This might lower profits and the related wages in the financial sector, but if it reduces what is called ‘systemic risk‘ then the wider social benefits from greater financial and economic stability could be substantial. The net social benefits to the whole economy over time would be positive and therefore justify the regulation.

This sort of argument, that what is good for the individual firm or sector may not be good for the economy as a whole, can also apply to the general process of economic development. In the following example, the reverse is the case: what seems bad for the firm may be good for the economy. In the long run development of capitalism, particular firms and sectors can grow for a while, then as consumer tastes change they can decline, go bust, and this often leads to job losses. This can seem bad for the firms or individuals involved, at least until the latter find new work, but as an economy makes progress, new firms and sectors are created and grow, contributing to long run transformation. In this case, the longer term outcome for the economy can be positive in terms of growth in productivity, incomes etc, but particular firms and individual employees may suffer until new opportunities appear.

Government subsidies for weak or declining firms and sectors can prove costly if they prevent inevitable structural change, which is one hall-mark of a capitalist economy. What is needed is support for worker retraining and relocation as well as some sort of unemployment benefit to temporarily support incomes, in the face of structural unemployment which arises from a changing composition of demand for labour over time. This was sadly lacking in the 1980s in the UK: the recession early in the decade resulted in a dramatic decline in manufacturing output and employment. A large number of the unemployed, particularly men, never worked again and ended up on sickness benefit. The subsequent boom was centred around financial and other service industries, and contributed to the rise of a pattern of two-worker and workless households and a polarization of job creation and prosperity. This structural change had a strong regional element as well, as decline was concentrated in the North of England, Wales, Scotland and Northern Ireland, and the boom was most marked in London and the South East. The Thatcher and Major administrations, in thrall to a free market philosophy, did far too little to mitigate these problems, which in some ways have persisted until today.

Thus behaviour at the micro level that seems to boost the profits of particular firms or sectors may prove very costly at the macro or economy-wide level, especially over the longer term. The reverse can also be true for the process of economic development. Financial regulation and supervision, while potentially reducing profits and wages in that sector, has the potential to stabilize the economy and reduce the need for the extremely costly bailouts we witnessed in 2008. Similarly efforts to tax or regulate pollution can shift the structure of the economy towards more environmentally friendly production. In the presence of externalities there is therefore a strong case for state intervention to improve economic efficiency. Vested interests which stand to lose from particular forms of regulation can make the politics of this difficult, so the presence of an economic case for these sorts of policies may not be sufficient to bring them to fruition. As ever, separating the politics from the economics may be unrealistic.

About Me

I have an MSc in development economics from SOAS, University of London and, while I now work for a charity, I remain passionately interested in the subject and how it can be used to promote sustainable human progress.
Apart from economics, I enjoy reading, walking, Qi Gong exercise, classical music, following professional tennis and athletics and spending time with friends and family. I also take an interest in politics, usually focussing on policy rather than personality, so that I don’t get too fed up with it.